Refiners Maintain a Firm but Legal Grip on Supplies

The motor homes showed up before dawn. Soon, hundreds of cars, trucks and sport utility vehicles joined the line, drawn by radio promotions for a new service station willing to sell gasoline for 90.3 cents a gallon for four hours.

In her boyfriend's Dodge Ram truck, Pam Silva spent 90 minutes waiting for her turn to fill up. Rising gas prices had put a big crimp in the household budget, and Silva figured the savings — about $47 to fill the 35-gallon tank — would be worth enduring the 1,000-vehicle line that formed early last year at the Encinitas Arco. "People like me, I have to care," she said. "I could use the money on some other bill."

Spurred by the escalating cost of oil over the last 18 months, gasoline prices everywhere have spent long stretches in record territory. But as this summer's car-trip season kicks into high gear, Silva and other California motorists continue to pump the most expensive fuel in the continental United States.

Some consumer advocates and politicians believe that the state's higher prices stem from unlawful manipulation by California's small band of gasoline producers. Government investigations have questioned some industry practices but have found no proof of illegal activities.

A more likely explanation: California refiners are simply cashing in on a system that allows a handful of players to keep prices high by carefully controlling supplies. The result is a kind of miracle market in which profits abound, outsiders can't compete and a dwindling cadre of gas station operators has little choice but go along.

Indeed, the recent history of California's fuel industry is a textbook case of how a once-competitive business can become skewed to the advantage of a few, all with the federal government's blessing.

"They don't have to collude, they don't have to form a cartel, they don't have to be monopolists," said Stanford University economist Roger Noll. "All they have to do is take advantage of the crazy rules."

Little more than a decade ago, California was awash in relatively cheap fuel.

But in 1996, the California Air Resources Board began requiring a special gas that was the least polluting in the world. Although the change did wonders for California's dirty air, it also was a first crucial step toward permanently eliminating the state's gasoline cushion.

One-third of the state's refineries closed, largely because they couldn't afford to comply with the new fuel rules. In addition, most outside suppliers were shut out of California because they couldn't make the unique blend.

Today, the state's gasoline comes almost exclusively from refiners in California, a group that has grown smaller and more powerful through mergers.

What's more, the gap between gasoline prices in California and the rest of the nation, once about 5 to 10 cents a gallon, has swelled in recent years. At times, the price difference has been as wide as 40 or 50 cents a gallon. That price chasm extracted an extra $3 billion from Californians in 2004 and an additional $1.5 billion so far this year, compared with the U.S. average.

California's fuel prices aren't their fault, the oil companies contend, but instead reflect the forces of supply and demand — with supplies constrained by environmental rules and demand booming because of population and economic growth. They note that other factors contribute to the state's costly fuel, including California's combined state and local taxes on gasoline, which rank third in the nation, currently adding about 37 cents to the 18.4-cent federal tax.

Yet along the way, refiners acknowledge, their California businesses have become the most profitable in the nation.

Most of the large oil companies operating in the state — Chevron Corp., Arco parent BP, Shell Oil Co., ConocoPhillips and Exxon Mobil Corp. — declined to make executives available to explain these market changes. Only Valero Energy Corp. and Tesoro Corp. agreed to discuss their operations; they and the oil industry's trade groups emphasize that refining earnings wax and wane in cycles and historically have lagged behind those of other industries.

"The industry needs to generate a decent income stream because it's forced to fund very large capital investments from time to time," said Rich Marcogliese, senior vice president for refining for Valero, which operates two fuel refineries and supplies nearly 700 service stations of various brands in California. Because the state's refineries strain to meet demand, the occasional problem "does generate periods of high margins, but they're not sustainable."

Still, the Golden State has been a bright spot for refiners even during less-profitable cycles.

"It turns out that they've been making decent money at it," said Severin Borenstein, director of the University of California Energy Institute in Berkeley. "Sometimes the margins aren't that great, but a lot of the time, they're really quite spectacular."

The saga of how California's laggard fuel market was transformed is detailed by internal oil company documents, government investigations, public records and the recollections of more than 50 of those who witnessed the evolution.

Refiners helped propel the turnaround with their collective focus on eliminating oversupply, seen in efforts to keep a small refinery closed in the late 1990s and to tightly control fuel stockpiles and imports. Their cause was helped by a parade of new fuel mandates and government regulations, community opposition to refineries, oil industry mergers, the loss of independent gasoline retailers and the state's relentlessly growing thirst for fuel, which now tops 43 million gallons of gasoline a day and exceeds demand in most countries.

What's more, the rest of the country isn't far behind. Many characteristics once unique to California — specialty fuels, a refinery shortage, the growing dominance of a few companies — have begun to plague other gasoline markets.

Tinkering with the lifeblood of a car-crazed state was no easy task. It required years of jousting over nearly every aspect of California's new recipes for diesel and gasoline, which debuted in 1993 and 1996, respectively, representing the most effective assault on smog since catalytic converters were added to cars in the 1970s.

In the early phases of the fuel debate, the oil companies tried to kill the new gas idea, going so far as to say it was technically impossible to make, said James D. Boyd, then the air board's executive officer.

"Their initial reaction was that it would be outrageously expensive and difficult," said Boyd, now a member of the California Energy Commission. The Western States Petroleum Assn. declared that the fuel proposal was "the most costly regulation ever considered for our industry."

State legislators seemed poised in 1989 to push methanol, a derivative of natural gas, as a replacement for gasoline. Hoping to head off a mandate that would kill demand for its fuels, Arco broke ranks with its brethren and disclosed that the industry could make cleaner-burning gasoline after all. In fact, Arco executives revealed at a hearing that the Los Angeles-based refiner had already cooked up some of the revamped gas and was ready to sell it to the public.

"It was a shocker," Boyd said. "I elbowed my deputy and said something to the effect of: 'We just won the battle, if not the war.' "

Thomas D. O'Malley, whose Tosco Corp. owned a refinery in Northern California, was among the first to see how he and others would profit from the new regulations.

In a speech to fellow oil executives in Reno less than two years before the new gas was introduced, O'Malley, then Tosco's chairman, predicted that the in-state supply would barely cover demand and that the new formula would command 6 cents a gallon more than the old.

"This is a very finely balanced system," O'Malley told the group. "If any of the large refiners in California experiences an unplanned shutdown, the premium of 6 cents could easily be two or three times that number."

O'Malley underestimated: The premium in times of duress has been more than 40 cents a gallon, Energy Department statistics show.

"My view for the industry was: Why in the world would you fight clean fuels? That's what the consumer wants," O'Malley, now the chairman of Connecticut refiner Premcor Inc., said in an interview. Make no mistake about it, the more stringent you make specifications, those become barriers to entry . Strong companies would have an advantage."

The state's move to strict new fuel formulas helped put 10 of 31 refineries out of business, cutting oil-refining capacity by 20%, according to the state Energy Commission.

The most conspicuous of the casualties was a small refinery in Santa Fe Springs known as Powerine. It closed in 1995 amid heavy losses, but less than a year later its owners wanted a reprieve from the new rules so they could jump back into the market or sell the plant.

The reemergence of Powerine, which could make a significant amount of gasoline despite its small size, was a threat to California's delicate market balance. In a February 1996 internal e-mail, a Mobil executive opined that if Powerine resumed production an expected 10-cent-a-gallon premium could shrink by as much as 2 or 3 cents.

"Needless to say, we would all like to see Powerine stay down. Full-court press is warranted in this case," the Mobil manager wrote in the message, which came to light through a lawsuit and subsequent U.S. Senate hearing. If the refinery were to reopen, Mobil could purchase and resell the output to protect prices, he added, noting that the company had tried that the year before and it "was a major reason" gasoline prices jumped 2 to 4 cents for several months.

Still in mothballs, Powerine was sold in 1997 to an investment trust run by televangelist Pat Robertson, who planned to spend $130 million to modernize and reopen the plant.

Neighborhood groups that remembered Powerine's environmental lapses had no interest in seeing the plant revived. Robertson accused unnamed oil companies of interfering with his efforts to raise funds for the project. He offered no proof at the time, and he declined requests for an interview.

The restart effort died shortly after a judge blocked construction at the behest of community groups that had accused local officials of insufficient environmental vetting.

Years later, California politicians and consumer activists accused Shell Oil of questionable motives after it announced plans to close its Bakersfield refinery in late 2004 without putting the property up for sale. Shell argued that the refinery's profits were too puny and the plant was too old, inefficient and small to attract serious buyers.

Shell's timing was curious because California refineries were earning record profits.

Critics doubted the company's rationale and said Shell's refusal to explore a sale laid bare its real objective: to cut California fuel production. That would trigger higher pump prices and boost profits for the state's remaining refineries, including Shell's other two, in Martinez and Los Angeles.

Investigations were launched by the Federal Trade Commission and California Atty. Gen. Bill Lockyer, who brought in an industry expert to review the refinery's prospects. The report wasn't made public, but author Malcolm Turner told The Times that closing the plant "flies in the face of common sense."

Shell sold the refinery in March to Flying J. Inc., a Utah-based truck-stop operator, for an estimated $130 million. Flying J executives plan to expand.

The refinery's survival was celebrated as a victory for California motorists. Two months later, the FTC closed its investigation, saying it had found no evidence that Shell was trying to increase gasoline prices by squeezing supply.

Today, 13 refineries in the state work at near-peak rates to make fuel to cover California's demand. The refineries also feed neighboring states, which consume 1 of every 7 gallons of the gas they make.

But the production isn't enough and must be supplemented with imports that the refiners bring in. That shortfall partly explains why refining has become so profitable in California despite expensive environmental upgrades and higher business costs, industry analysts say.

Although oil companies don't disclose California profits, refining margins as measured by the "crack spread," an industry calculation used to approximate profits, have been as much as three times as high as elsewhere in the country.

Oil companies say extensive refinery expansions haven't happened in California because the state's permitting process is too onerous. Refiners have spent as much as $7 billion since the 1990s on various projects, including the switch to cleaner fuels, said Joseph Sparano, president of the Western States Petroleum Assn.

"There have been some horrible years for this business," Sparano said. "Just knowing that, why would a refiner rush to expand?"

Cal Hodge, a former Valero Energy manager, added another factor: Refiners realize that restraining production pays off. "You look better because you let the environmentalists limit the capacity," said Hodge, now an industry consultant.

Similarly, energy companies benefit from keeping only a limited supply of fuel on hand. Oil companies have converted to this "just-in-time" practice across the nation, but the inventory squeeze is most dramatic on the West Coast, where refineries stockpile about 18 days' worth of fuel compared with 30 to 35 days elsewhere in the U.S., according to Stillwater Associates, an Irvine consulting firm.

There are sound economic reasons for this, oil companies say. Because prices are so volatile, it's risky and expensive to hold millions of dollars' worth of fuel, and it's costly to build additional storage tanks. But with so little gasoline on hand, the tiniest of refinery glitches can cause retail prices to skyrocket because replacement supplies must come from outside markets and can take four to eight weeks to arrive.

" 'Just in time' means that it's never there when you need it," said Mark Cooper, director of research at the Consumer Federation of America.

In addition, California's refiners control most of the tanks, port terminals and other infrastructure vital to importing and moving fuel from place to place in California. Gasoline traders tell cautionary tales of homeless tankers of fuel that refiners wouldn't allow to be unloaded at California ports. Because oil-rich California grew up as an exporter, there are no pipelines that can bring fuel into California from refining centers such as the Gulf Coast.

"You have access problems: Those that are there don't want those that are not there to come in," said Drew Laughlin, an energy consultant who has done studies for the California Energy Commission. Compared with New York's harbor, where gasoline imports flow in from Europe, Laughlin said, "you don't have as much storage, you don't have as many importers, and the vast majority of your market is dominated by the refiners."

Consumer Federation and others say such control stems from massive consolidation in the oil business, giving fewer players a bigger share of the market and its key assets. The concentration also has strengthened the industry's political clout, which critics say has thwarted most market-altering legislation.

More than 2,600 mergers and acquisitions have occurred in the U.S. petroleum industry since 1991, according to the Government Accountability Office, Congress' watchdog agency. Some have paired the biggest names in oil, including British Petroleum with Amoco and Arco, Exxon with Mobil, Conoco with Phillips, and Chevron with Texaco.

The trend has been especially acute in California, where six major oil companies control more than 80% of the capacity to refine oil. In 1990, the six largest companies accounted for 69% of refining capacity.

The boiling down of the market brought higher gas prices, according to the GAO report. The agency examined eight oil industry mergers from 1994 to 2000 and found that six raised gas costs in certain places. "The price increases were particularly large in California, where they averaged about 7 cents a gallon," the GAO concluded.

The oil industry rejects any direct correlation between mergers and higher prices, and the Federal Trade Commission called the GAO report "fundamentally flawed."

"It's a nice theory, but every other major industry has a higher concentration than we do," said John Felmy, chief economist for the American Petroleum Institute, an oil industry group.

Nonetheless, the FTC and Lockyer objected to several of the mergers, and their intervention yielded important concessions. Merger-related divestitures required by the government brought Valero and Tesoro into the California market, where the two independent refiners have helped keep competition alive by selling much of their fuel to unbranded dealers.

Despite those efforts, several economists and regulators say California's fuel industry has become an oligopoly, meaning that acts by any one of a handful of operators can move prices throughout the market.

"As California's gasoline market continues to tighten, the result will be both greater price premiums due to real scarcity and the potential for greater premiums due to the ability of some firms to exercise market power," Borenstein of the UC Energy Institute concluded in a recent study for the state Energy Commission.

Tesoro Vice President Lynn Westfall said California's fuel woes stemmed not from oligopoly power but from the state's growing reliance on imported gasoline and gas components. With supplies coming from as far away as Europe, Westfall said, "any disruption in local supply is going to cause a lot of market volatility, which will appear as market power, but it's not."

The mere presence of market power is not illegal under antitrust laws, said Mozelle Thompson, who served on the Federal Trade Commission for 6 1/2 years before resigning in August. "The oil industry hires the best, and they're very good at knowing where the bright lines of antitrust law are and coming in just underneath them," Thompson, who has helped review many of the largest oil mergers, said in an interview.

Even traditional antitrust concepts such as collusion are easy to dodge, critics say. The oil companies, for example, are constantly sharing their sensitive information about supply, pricing and strategies, but the information gets passed through third parties such as consultants, pricing services and others, said Los Angeles lawyer Thomas Bleau, who has sued oil companies on behalf of gas station dealers.

In recent years, several investigations have raised questions about certain retail and wholesale pricing practices but brought no fines, settlements or criminal charges.

"Thirty investigations in the last 20 years have yielded a significant amount of evidence that says there is no wrongdoing, there is no collusion or all the other things that people have called for investigations about," said the oil industry's Sparano.

Even so, the refiners' command over the market can be seen at work at the gas pump, dealers say.

On a Redondo Beach corner, gas station owner Mike Madani has ridden out 14 years of wrenching change.

Four dealers once battled for customers at the intersection of Artesia and Aviation boulevards. Now, Madani's South Bay Shell is the lone survivor. Although his gasoline prices this year were higher than ever, Madani figures he'd be out of business too if he hadn't added a carwash and a convenience store.

The 58-year-old dealer says there has been little growth in his fuel profits, which the onetime pump attendant tallies daily in a tiny office dotted with vintage fuel signs. That's because, he says, Shell keeps strict control over his gasoline operations. Although he chafes at the arrangement, Madani says he has little choice because all of California's refiners work that way.

"The majors, they have control over everybody," said Madani, who sued Shell in December over their fuel pricing relationship. The case is still pending.

In recent years, industry mergers, changing retail strategies and costly environmental upgrades have thinned the ranks of service stations. California has been hit hardest. In the late 1990s, the state was home to about 12,200 gas stations, about 7% of the U.S. total. By 2002, the state had lost more than 2,000, accounting for a disproportionate 21% of station closures nationwide, according to a 2004 FTC study.

The declining station count has weakened competition and made it easier for the state's major oil companies to impose their will on gas station owners, down to the profit earned on each gallon sold, dealers contend.

Eight out of every 10 gallons of gas sold at retail in California are dispensed at stations with brand names such as Arco, Chevron, Shell and 76. Major oil companies own some of those retail sites, but most of the state's branded stations are owned independently, like Madani's Shell, or run by franchisees who work under restrictive contracts.

The rest of the gasoline, about 20%, flows from unbranded independent retailers under names such as Rotten Robbie and EZ Gas. That presence is unusually small; such unaffiliated retailers command an average of 30% of gasoline sales nationwide, according to the Lundberg Survey, an industry publication based in Camarillo.

Refiners set each dealer's wholesale fuel cost, known as the dealer tank wagon price, which establishes a de facto floor under retail prices. Dealers say an oil company can push up retail prices overnight by hiking the fuel costs to its stations.

The relationship between dealers and oil companies is fractious, generating several class-action suits that accuse the corporations of unfairly dictating gas station profits through dealer tank wagon prices, lease charges and other fees. Dealers, who contend that the corporations electronically monitor every aspect of their operations, say they typically are allowed to earn 5 cents to 10 cents a gallon.

"Arco allows you to have a 6-cent profit," said Wilmington dealer Charlie Mulcahy, the oil company's youngest dealer when he started 25 years ago at age 22. If he were to raise pump prices by 2 cents a gallon, Mulcahy said, Arco's daily survey would pick it up "and if they didn't want me to have that 8-cent margin, then the next day my dealer tank wagon price would go up 2 cents."

Refiners "not only control how much supply is in the marketplace, they control who gets it and at what price," said Dennis DeCota, who runs a 76 station in the Northern California town of San Anselmo and is executive director of the California Service Station and Automotive Repair Assn., a dealer group.

Such influence wouldn't loom so large if the state still had a healthy base of independent retailers, considered by economists to be a key force in properly functioning fuel markets. California lost more than 250 independent stations in 1997 when Thrifty Oil Co. surrendered to Arco after a damaging price war, causing prices to rise 4 to 6 cents at stations near the Thrifty sites that were taken over by Arco, according to a study by Yale University economist Justine S. Hastings.

Oil company representatives declined to discuss their dealer arrangements in detail. However, Ken Applegate, Valero's vice president of wholesale marketing, said flatly: "Dealers set the street price levels. I would not agree that oil companies have control in this area."

Pam Silva, a dedicated price watcher, doesn't care much who's to blame for soaring pump prices. She just wants gas to be cheaper.

Expensive fuel has exacted a price from the 48-year-old Silva and her boyfriend, Chuck Kitching, 51, who share a home in Temecula. Silva quit her last job — cleaning houses — because it required an hourlong one-way commute, and the gas bill ate up too much of the paycheck. Down to one income, Silva and Kitching, a heavy equipment operator, have reined in expenses and given up cherished monthly getaways to the desert.

"We just do the necessities," Silva said. "When one's not working we just have to make cuts."